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The markets are flashing signs of another February-sized correction.
After setting an all-time high on September 2, 2020, the S&P 500 tanked 3% on a massive volume spike the following day.
This downfall continued for the next two days, dropping the S&P 500 down 5.4% on three days of high-volume selling.
Stock portfolios may be in store for another 35% drop, and COVID-inspired economic conditions, such as fear of a resurgence and a postponed vaccine date, certainly support it.
But while most investors bite their nails in worry, I’m anticipating nothing but profits.
Should the markets go red, collecting high-probability profits will be the name of the game – and today, I’m going to show you exactly how to do just that.
You can double your profit potential in a bear market with a single trade. Click here to see the details…
Profit on the Impending Bear Market using Credit Spreads
The question that I’m sure is on your mind is: “What is indicating a market correction?”
It’s a good question, and I’m more of a “show don’t tell” kind of guy, so let’s take a look at the SPDR S&P 500 ETF Trust (NYSE: SPY).
SPDR S&P 500 ETF Trust (NYSE: SPY)
Simple support, resistance level, and volume analysis are what we look at for the answer.
- The volume on the recent two-day run up declined. Stated another way, the institutional conviction declined on the run up, suggesting that this run doesn’t have legs and will fail.
- There is strong resistance at $342 with four bounces off this level over the past six trading sessions.
- This $342 level appears destined to hold. If it doesn’t, there will likely be more upside.
- Strong support exists at the $300 level. A close below this level on above average volume will signal more downside.
Now, with any major news event or government decision, this could change. But given the amount of institutional selling over the past couple of weeks, the most likely direction is down – perhaps way down.
And I have one simple signal to look for that proves this further move to the downside…
If the SPY closes < $330 on above average volume, this will be the trigger that sends the market lower.
And this trigger is the key to these credit spreads.
Should this move happen, collecting profits will be like shooting fish in a barrel.
With this signal in place, the likelihood of the SPY closing back above $330 for the short term will be very low.
What we need is a trade that will profit as long as the SPY stays below the $330 level.
In other words, we need a trade that profits if the SPY continues to tank, goes sideways, or even goes up a little.
Sound too good to be true?
It does, but this is achievable using the right options play.
To begin, there are two sides to any option trade: A buyer and a seller. You can think of it like a long (buyer) and a short (seller) side.
For example, on the other side of a long XYZ $50 call there must be a short XYZ $50 call.
| Long Call |
Short Call |
| Buy XYZ $50 Call |
Sell XYZ $50 Call |
| Bullish |
Bearish/Sideways |
The long call makes money when the stock rises.
The other side of the trade – the short call – makes money when the stock does not rise. In other words, the short call makes money if the stock drops or goes sideways.
If you assume that a stock has an equal probability of going up, down, or sideways, the long call has a 33.3% chance of making money. This means that the short call has a 66.7% chance of profit.
The simple act of selling a short option actually doubles your probability of profit.
Well, all trading has “tradeoffs,” and shorting calls is no exception. But as long as you know the best trading strategies to use, these risks shouldn’t be anything to worry about.
Here are a couple of them:
The most you can make on a short call is the amount you take in for selling it. If you sell an XYZ $50 Call for $1.00, the most you can make is $1.00. Ideally, the short call will expire worthless. You may even choose to buy it back for $0.20, netting $0.80.
Long calls give you the right to buy a stock. The other side, short calls, give you the obligation to sell a stock. That’s fine if XYZ is at $50 or less. However, if XYZ makes a bullish run and is trading at $70, you’ll be obligated to sell a $70 stock for $50 and lose $20. There is no limit to how high a stock can go, so, short calls have unlimited risk. They are called “naked calls” for this reason.
Now, these limited profits are still great profits! And when you have an impressive 67% chance at profits, the difference is worth it.
Unlimited risk can sound intimidating, but as long as you protect your trade, then you have nothing to worry about.
And you can do this by acquiring a right to cover your obligation.
Here’s what I’m talking about:
Selling an XYZ $50 call gives you the obligation to sell XYZ at $50.
To cover the risk of the stock rising, you could buy an XYZ $55 call, giving yourself the right to buy XYZ at $55, capping your risk.
| Long XYZ $55 Call |
→ |
Right to Buy at $55 |
| Short XYZ $50 Call |
→ |
Obligation to Sell at $50 |
The spread now has limited risk. In the example above, if the stock went to $70, you’d be covered by the long $55 call. If you were forced to sell XYZ at $50, you could exercise your right to buy it back at $55, capping your risk to $5.
Welcome to the world of credit spreads – higher probability, limited risk trading.
Here are some basic rules to get you started with Short Call Spreads (aka: Bear Call Credit Spreads):
- Sell ATM/OTM Call
- Buy Higher Strike Call
- 1-10 Points Between Strikes
- Use 14 to 30-day Options
Remember, short call spreads are a bearish strategy. Be sure to sell them at or above a price point you feel the stock will be beneath in two to four weeks.
I determine this “line in the sand” with the following formula:
Stock Close < Support + Above Average Volume
With all of the above established, I’ll leave you with this “Shooting Fish in a Barrel” trade on the SPY.
Entry: Close < $330 + Above Average Volume
Trade: Sell Two-Week $330 Call + Buy Two-Week $335 Call
Profit Exit: Buy Back Spread for 20% of Original Credit (80% of max profit)
Loss Exit: If SPY Closes > $330.50, Buy Back Spread
Here are the legs to close or buy back this credit spread:
Sell Two Week $335 Call to Close
Buy Two Week $330 Call to Close |
Should we get our entry signal, this trade will have at least a 67% probability of profit.
If the SPY continues to break below support on above average volume, keep selling these high probability credit spreads.
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Talk soon,
Tom Gentile
America’s #1 Pattern Trader
